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When China sells goods to the US, the dollars that they receive in exchange are held in the US at a US reserve bank. This is a crucial point; the dollars never leave the US banking system. Once the Chinese have these dollars they can buy US dollar denominated goods and services, sell the currency to a willing buyer for another currency, hold the currency in the reserve account (earning 0%) or buy a treasury note or bill which will give them a small interest return on their deposit.

Even though the "dollars" remain in the U.S., held at a U.S. reserve bank, do the Chinese not expect that a certain value adheres to those dollars? I mean, we can't just decide the dollars they "have" are worth less than they were when the Chinese obtained them and expect no protest? Can we?

They can protest but what else can they do? Declare war on us? Stop exporting to the largest consumer market on the planet?

By holding US dollars they are assuming all the risk that any holder of the currency assumes (inflation chief among them) but, in addition to the inflation risk, foreign holders also have other political risks. Do you recall back in 2005 when Chinese Oil company CNOOC tried to buy American oil company Unocal? They ended up withdrawing their $18.5 billion offer due to American political resistance to allowing the Chinese to own these strategic US assets. This is a clear example of the political risk that the Chinese assume by accumulating US dollars. Effectively the US possesses a seller's option to provide goods and services to China in exchange for their dollars. Possessing a US dollar does not give you a right to US goods and services but rather gives the seller of US goods and services an option to sell (option meant in the financial sense; like a stock option). In other words, we don't have to exchange any goods and services for those dollars if we don't want to.

If we paid China off, basically moving their saved dollars from a time deposit (US treasury) to a demand deposit (China's reserve account) all we would be doing is giving the Chinese liquidity in dollars. As I mentioned above, the Chinese would then have an option to buy US dollar denominated goods and services or save those dollars at a 0% interest rate (sure they could exchange them for another currency but then the new owner of the USDs would be in the same position as China just was with a choice of whether to spend or save them). If the Chinese (or whoever they sell the currency to) choose to buy dollar denominated goods and services, that will increase US demand and boost production.

If we owed China Yuan, the situation would be much more dire. We cannot create Yuan thus China would have a real claim on goods and services as the US would need to sell goods and services to acquire yuan to settle with China.

So given this, the obvious question then becomes "What advantages does China get from selling us goods and services for US dollars"? The answer: The act of exporting to the US helps keep chinese domestic employemnt up and their economy running. In addition to the US dollar, the Chinese are acquiring a host of other currencies and will continue to do so as long as as they need to run a current account surplus to support domestic production. Additionally, they maintain a large currency reserve in USD which allows them to keep the yuan pegged to the USD thus making their exports more attractive.

From: A New Yorker in DC
Gender: Male
Politics: Independent
Party affiliation: None

QUOTE(brinn)

Stop exporting to the largest consumer market on the planet?

Yes. You are under the false assumption that our consumption is the driver of the world economy. This is wrong. We are the caboose. The producers are the engine of the economy. China has 1.3 billion consumers. If the Chinese finally allow their currency to appreciate - something that will happen anyway since the US is pursuing a policy of intentional devaluation - every Chinese citizen will get the equivalent to a giant pay raise. They don't need us. They can consumer their own products. This WILL happen eventually. The developing world will decouple from the US economy and continue to go strong. We are the world's largest debtor. We can't pay off our debts. Eventually the world will figure this out.

Yes. You are under the false assumption that our consumption is the driver of the world economy. This is wrong. We are the caboose. The producers are the engine of the economy. China has 1.3 billion consumers. If the Chinese finally allow their currency to appreciate - something that will happen anyway since the US is pursuing a policy of intentional devaluation - every Chinese citizen will get the equivalent to a giant pay raise. They don't need us. They can consumer their own products. This WILL happen eventually. The developing world will decouple from the US economy and continue to go strong. We are the world's largest debtor. We can't pay off our debts. Eventually the world will figure this out.

Who has the largest GDP on the planet? And what happens when the yuan appreciates and the trade surplus begins to shift in our favor? You're assertion that we can't pay our "debts" is patently false. The "debt" could be paid tomorrow with nothing more than an accounting entry. Operational fact. Not economic theory.

From: A New Yorker in DC
Gender: Male
Politics: Independent
Party affiliation: None

QUOTE(brinn)

Who has the largest GDP on the planet?

The US for now. But what does that matter? GDP includes government spending and consumption. Consumption is a consequence of economic growth, it is not the driver of it. We are only able to consume because we borrow from places like China, Japan and Saudi Arabia. Once the borrowing stops because interest rates rise, the party is over.

QUOTE(brinn)

And what happens when the yuan appreciates and the trade surplus begins to shift in our favor?

Why would that happen? What are we going to export? Why do you assume that the US would be the ones who be doing the exporting instead of another developing country in Asia or Africa?

QUOTE(brinn)

You're assertion that we can't pay our "debts" is patently false. The "debt" could be paid tomorrow with nothing more than an accounting entry. Operational fact. Not economic theory.

It would destroy our economy! The debt is insurmountable without causing massive depression. Our debt obligations far exceed our ability to ever pay it. Either we would raise taxes to such absurd levels that it would leave nothing for the productive economy or we would inflate away our debts which would destroy our currency and make our savings and capital evaporate. There is no easy way out of it. We can have an honest strategic default on our debt or we can choose to destroy our currency. Those are the options.

Maybe Maybe Not: "Even though the 'dollars' remain in the U.S., held at a U.S. reserve bank, do the Chinese not expect that a certain value adheres to those dollars? I mean, we can't just decide the dollars they 'have' are worth less than they were when the Chinese obtained them and expect no protest? Can we?"

They can protest but what else can they do? Declare war on us? Stop exporting to the largest consumer market on the planet?

Wow. Seriously? You might be surprised what people (and countries) will do when pushed too far. (I won't be.)

I agree that there are complexities to the situation that might restrain the Chinese (or anyone else) from taking action lightly. But I agree with Hobbes from his post #2 in this thread - war isn't out of the question.

It seems that the U.S. and much of Europe has become obsessed with deficits, debt reduction and austerity. The question for debate is simple:

What do you see as the negative economic effects of persistent deficits?

If asked this question 25 years earlier under Reagan's term, the typical American would not care. In fact even with the current state of America's economy, I don't think the typical American is thinking about the possibility of a complete financial collapse, though I wouldn't rule that out.

I think it boils down to Envy. I'm sorry to mention that word because some other posters have accused me of that when I talk about issues such as the disparity between the rich and the poor in America, but I can explain nonetheless. Throughout the economic crisis of the past 5 years, the Government has given hundreds of billions of dollars in bailouts to companies that American taxpayers feel are unworthy and in the midst of those bailouts, some of the bailed out companies have continued paying lavish salaries and benefits to their top employees. That kind of distrust has helped waken a lot of Americans up to a lot of other financial issues in the Government such as Sweet Heart contracts, High Salaries for politicians, and the suspicion that some Civil Servants are being paid middle class salaries for unproductive work.

The reasons that Americans should be questioning the Federal spending lies partly in the fact that people who work in the Federal Agencies, and the Federal Contractors, are in the solid middle class range with most of the health benefits paid for, enough vacation time and money to travel, and retirement benefits if an employee works long enough. All that, while many Americans outside the beltway are losing their middle class lifestyle. If the Federal Government cannot fix the economy in terms of growing the middle class again or delivering justice to the White Collar crooks on Wall Street, the rest of America will become very wary of supporting a big bureaucracy. As much as I would like the see the Federal Government fix the economy, I do not expect them to create 20 million office jobs, nor do I wish to see the Government try such a thing.

We are only able to consume because we borrow from places like China, Japan and Saudi Arabia. Once the borrowing stops because interest rates rise, the party is over.

We do not borrow from China, Japan, nor Saudi Arabia. What we are doing is financing a foreign desire to save in US dollars. The relationship is much more akin to a consumer depositing funds in a bank. The US is effectively the bank and China, Japan and Saudi are the consumers. They take their US dollar earnings (not Yuan, Yen or Riyal) and buy a bond because their choices are limited to earning a positive interest rate or earning zero. The same reason you place your dollars into a savings account at a bank. As you know, deposits held at a bank are held as liabilities on the bank's balance sheet. The bank owes you these deposits back thus the bank is "borrowing' from you in exactly the same manner that the US "borrows" from China, Japan, and Saudi. So the question then becomes, when was the last time you heard of a bank shutting down because they were attracting too many depositors?

QUOTE(Leder)

QUOTE(brinn)

You're assertion that we can't pay our "debts" is patently false. The "debt" could be paid tomorrow with nothing more than an accounting entry. Operational fact. Not economic theory.

It would destroy our economy! The debt is insurmountable without causing massive depression. Our debt obligations far exceed our ability to ever pay it. Either we would raise taxes to such absurd levels that it would leave nothing for the productive economy or we would inflate away our debts which would destroy our currency and make our savings and capital evaporate. There is no easy way out of it. We can have an honest strategic default on our debt or we can choose to destroy our currency. Those are the options.

Just as the Bank always shutters their doors when they repay your savings account by moving your balance to a checking account, right?. Once the "debt" is "repaid" (effectively moved from the fed reserve bond accounts to the fed reserve "reserve" accounts) it is possible that liquidity would need to be drained from the system to avoid inflation (done via, more bond sales, increased taxation or increased rates) but that would only need to be done if the holder of the funds (China for example) decides to spend their dollar holdings by purchasing dollar denominated US goods and services. With all due respect, strategic default or hyperinflation are only considered reasonable options because of a lack of understanding of how the monetary system actually works. Once one gains an understanding of reserve accounting and sectoral balances the economics become much clearer, more logical and straightforward. Your assertions were once accurate but inapplicable after 1971 when the US converted to a completely non-convertible, floating fiat currency. Your citing gold standard theory and advocating gold standard policies in a fiat currency environment.

We do not borrow from China, Japan, nor Saudi Arabia. What we are doing is financing a foreign desire to save in US dollars. The relationship is much more akin to a consumer depositing funds in a bank. The US is effectively the bank and China, Japan and Saudi are the consumers. They take their US dollar earnings (not Yuan, Yen or Riyal) and buy a bond because their choices are limited to earning a positive interest rate or earning zero. The same reason you place your dollars into a savings account at a bank.

And the dollars deposited in our bank by others are then essentially loaned back to ourselves to finance a government that is spending way more than it takes in. The effect is the same as a loan although the financial reality may be more complex.

So when those others ask for their deposits back and we don't have anything to give them, or the bank says the billion dollars they put in are really only worth 8 or 9 hundred million, those others get upset.

QUOTE(brinn @ Nov 7 2010, 10:53 AM)

As you know, deposits held at a bank are held as liabilities on the bank's balance sheet. The bank owes you these deposits back thus the bank is "borrowing' from you in exactly the same manner that the US "borrows" from China, Japan, and Saudi. So the question then becomes, when was the last time you heard of a bank shutting down because they were attracting too many depositors?

Really? That's an accurate description of what's happneing? Other countries are "rushing" to deposit all their money in the U.S.?

What's happening is that some big customers with a lot of money already deposited are getting skittish about the bank's solvency and hoping it doesn't fail.

... Iím not claiming that the US can print $1,000,000 for each and every citizen without consequence ......

Why not?

Operationally, it could. Functionally, it would cause inflation.

How about just $45,000 (per citizen share of U.S. National Debt)? Or just $15,000 (per citizen share of U.S. debt held by foreigners)?

At what point does the "functional finance" model, upon leaving the "frictionless" world of theory, crash headlong into the "immovable object" of reality (e.g. "Stop diluting the value of the money I've worked so hard to make, or else!!!") and ceases to function (pun intended)?

Really? That's an accurate description of what's happneing? Other countries are "rushing" to deposit all their money in the U.S.?

Yes, what I wrote is an accurate description. Your interpretation of what I said is not. What other countries are "rushing" to do is to sell their goods and services to the US consumer. Once they have sold their goods and services they have no choice but to "deposit" their funds in the US reserve bank as that is how the payment for goods and services in US dollars clears. They have no other option if they are accepting US dollars. Their choice is then to convert their reserve balances to treasuries and earn interest or leave the funds in their account and maintain liquidity but forego a return on their holdings.

QUOTE(MMN)

And the dollars deposited in our bank by others are then essentially loaned back to ourselves to finance a government that is spending way more than it takes in. The effect is the same as a loan although the financial reality may be more complex.

No. It may appear that bond proceeds and taxes are funding our spending but they are not. Both taxes and bonds sales are liquidity drains but are not necessary for funding. What does it mean to loan ourselves something that we can create at will? Go back to my analogy of the business cards and the household. Does the father need collect business cards from his kids in order to issue more?

QUOTE(akaCG)

How about just $45,000 (per citizen share of U.S. National Debt)? Or just $15,000 (per citizen share of U.S. debt held by foreigners)?

At what point does the "functional finance" model, upon leaving the "frictionless" world of theory, crash headlong into the "immovable object" of reality (e.g. "Stop diluting the value of the money I've worked so hard to make, or else!!!") and ceases to function (pun intended)?

This has been done before. What were Bush's 2008 tax rebate checks but exactly this on a smaller scale? Aside from the moral hazard of such a course, it would likely allow private households to deleverage significantly. It would boost aggregate demand and the increased demand would likely begin to lower unemployment levels. Once employment levels have increased and the output gap decreases any additional spending would be inflationary. The government would need to increase taxes and increase rates to drain liquidity and dampen economic activity. Inflation will not increase while unemployment is is this high and subsequently, the output gap is extremely large. Only spending in excess of the economy's ability to produce will produce inflation.

Really? That's an accurate description of what's happneing? Other countries are "rushing" to deposit all their money in the U.S.?

Yes, what I wrote is an accurate description. Your interpretation of what I said is not. What other countries are "rushing" to do is to sell their goods and services to the US consumer. Once they have sold their goods and services they have no choice but to "deposit" their funds in the US reserve bank as that is how the payment for goods and services in US dollars clears. They have no other option if they are accepting US dollars.

So they want the U.S. consumer, they just don't trust the financial intermediary they must go through to do so?

What's the difference? If they don't believe they're getting a fair shake from the financial intermediary, the whole thing falls apart. (Especially when they realize the buying power of the people they're selling to is being artificially propped up by their own money.)

Trust is a must.

QUOTE(brinn @ Nov 7 2010, 02:36 PM)

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QUOTE(MMN)

And the dollars deposited in our bank by others are then essentially loaned back to ourselves to finance a government that is spending way more than it takes in. The effect is the same as a loan although the financial reality may be more complex.

No. It may appear that bond proceeds and taxes are funding our spending but they are not. Both taxes and bonds sales are liquidity drains but are not necessary for funding. What does it mean to loan ourselves something that we can create at will?

We can't create it at will. Not without consequences. You've said so yourself.

So they want the U.S. consumer, they just don't trust the financial intermediary they must go through to do so?

What's the difference? If they don't believe they're getting a fair shake from the financial intermediary, the whole thing falls apart. (Especially when they realize the buying power of the people they're selling to is being artificially propped up by their own money.)

Trust is a must.

Based upon the trade deficit I'm seeing no lack of trust in the US currency. But let's assume that the dollar begins to lose value because foreign holders begin to sell the dollar for other currencies. What happens to the relative value of goods and services produced by a nation when the value of their currency drops? I'm sure you know that the goods and services produced by the country with the weaker currency become more affordable for nations with a stronger currency. This shifts the balance of trade in favor of the weaker currency. Agreed? If the value of the US dollar drops, our exports become more attractive and the "evil" trade deficit begins to shrink. This is currently, exactly the goal of the Obama administration as they try to coerce China to unpeg the Yuan and let it float freely. Does it not trouble you that what you fear (foreigners not wishing to save in our currency) is currently the explicit goal of our foreign economic policy with China?

The real wealth of a nation is all the goods and services it produces plus all the goods and services it imports minus all the goods and services that are exported. This is essentially known as the real terms of trade and, currently, it is heavily weighted in the US' favor. If Obama's efforts to get the yuan to float are succesful our trade defict will shrink and our real terms of trade with China will suffer.

QUOTE(MMN)

We can't create it at will. Not without consequences. You've said so yourself.

There is no free lunch.

We can create it at will if we understand how to manage the consequences of our actions. Question for you MMN: Why hasn't all the stimulus and two rounds of QE failed to move inflation?

As long as the US economy remains productive, and as long as we do not borrow in a foreign currency, and as long as we have the political will to drain liquidity once the output gap shrinks, we'll be fine. Of course, the last requirement in the list is the one we need to worry about most as politicians have shown a tendency to do what is best for them rather than what is best for the country but if the operational realities of the monetary system were more widely understood it wouldn't be difficult to hold politician's feet to the fire if inflation began to increase. Besides, inflation is a long way off and won't become possible until the outgap gap shrinks considerably. Only spending above and beyond the economy's capacity to produce more goods and services is inflationary.

We can create it at will if we understand how to manage the consequences of our actions. Question for you MMN: Why hasn't all the stimulus and two rounds of QE failed to move inflation?

Better yet, why hasn't all the stimulus and two rounds of QE stimulated the economy? You seem to have a very short term memory when you talk about there being "no inflation" despite all the money the Fed has pumped into the economy. Not too long ago, gasoline was selling for over $4/gallon, and before that, houses were skyrocketing in value with all the cheap credit going around.

Your idea about the value of the currencies adjusting via the Free Market and re-adjusting the flow of goods to balance out the Trade Deficit seems like a good idea, except for one thing. International Trade doesn't happen in a Free Market. Most of the Trade Agreements that get negotiated tend to favor politically well connected firms on both sides of the Ocean instead of the market place deciding. Rarely do these imbalances get resolved with happy endings. A lot of "Free Market" economists thought that the Chinese consumers would have loads of cash to buy American products after America running up gargantuan trade deficits with that country for 2 decades now. Instead, a lot of the surplus money ended up going into a Real Estate Bubble over there while a relatively small number of factory owners profited from the trade deficits.

I just want to say I'm enjoying the spirit of debate here. I don't know alot about economics (more cars and computers), but it seems like folks need to get a better handle on how the economy works. Seems like we elect politicians that mainly play to our fears and hopes, but nothing changes for our better. Sol it's boom and bust, with the left saying we have to chop off the right side of the ship and throw it overboard. We get sick of that and elect the Right, who says we have to chop off the left side of the ship and throw it overboard and so it goes until we're ALL left walking the plank. Hopefully nobody will decide that the masts have to go overboard to save the country. Of course, after the left and right sides of the ship are chopped off, maybe everybody will get together in the middle and decide that it's better to come up with a new plan than it is to drown. I don't understand political theory; I'm kind of tired of political pie-in-the-sky on both sides of the fence anyway.

Now, what I understand from what I've been reading is that the U.S. economy isn't based on the gold standard anymore and that the U.S. can't run out of it's own currency or be indebted in it's own currency. I also understand that the Gov't can't spend one way that will fix America forever, just like you can't eat a meal that will satisfy you for the rest of your life.

Please try to keep it simple. Seems to me there's a lot on the line here and while I can't say our elected officials are ENTIRELY out for their own good, it's not going to do us any good to hire politicians to help us get back to work if they don't know how the economy works. From what I've read here, any of 'em that talks about U.S. bankruptcy should get a pink slip, and that damn soon. The changes need to start with us. We can't make proper decisions if WE don't know the facts. Let's lay out some facts, right here.

Better yet, why hasn't all the stimulus and two rounds of QE stimulated the economy?

Simple Answer: Because the stimulus largely went to wall st and banks to help shore up their balance sheets in the mistaken belief that banks weren't lending because they were reserve constrained. I'm an executive at relatively small bank and I can assure you that when we make a loan we don't care about the level of deposits in our bank because we know that if our reserve calculation falls short at the end of the calculation period we can borrow money in the interbank market. When we make a loan all we care about is the spread between our cost of funds and the rate on the loan and the borrower's ability to repay. That's it.

So the reason that the stimulus has had no effect is because it wasn't properly targeted. What we are experiencing is a balance sheet recession where main st. has too much debt. The stimulus did nothing but add to bank reserves and the money isnít actually getting into circulation. Main Street deleveraging continues unabated. Additionally, high unemployment and idle production capacity exacerbates the situation. As it stands, banks are holding cash, loan demand is weak and velocity is minimal.

Reagrding, QE: Operationally it is a non-event and is likely actually deflationary in nature. QE basically purchases private holding of treasuries and provides cash (reserves in banks). It replaces an interest earning asset with a non-interest earning asset and forces the holder of the cash to seek other areas of investment. It will lower rates further along the yield curve as the feds purchase longer term bonds with this round of QE. Because QE is simply an asset swap and adds no real assets to the private sector it has no net effect on the level of private sector wealth and serves only to lower rates further and force savers to seek alternative investments.

Have to go to work now but I'll respond to your inflation concerns later today.

It seems that the U.S. and much of Europe has become obsessed with deficits, debt reduction and austerity. The question for debate is simple:

What do you see as the negative economic effects of persistent deficits?

Payment of interest. Which amounts to money lost to the bad habit of overspending. Money spent on interest is not available for other uses and often requires increased Taxes to reduce deficits. Increased Taxes reduce economic activity and may lead to even more borrowing.

The recent election indicates that consumers are not lost on the issue. Out of control and pork barrel spending needs to end Ė Now

QUOTE

In FY2010, the Treasury Department spent $414 Billion of your money on interest payments to the holders of the National Debt. Compare that to NASA at $19 Billion, Education at $93 Billion, and Department of Transportation at $78 Billion.http://www.federalbudget.com/

Thanks Brinn. That helps me understand what's going on with QE and why it's not helping restore jobs. The banks are scared to lend and the borrowers are scared to borrow. Can't say that I blame them.

So the Fed just keeps doing the same thing and it seems it's not helping that much. Is there anything else the Fed can do or are they just a one trick pony?

On inflation, it seems that bubbles have had a much more destructive effect on our economy than general inflation has. I'm not sure how to address that so we can head off the next bubble. Seems like there's always the sociopathic element, from the guy that says "I'll get the loan, gut the house and sell the pieces on Craigslist" to the corporate version of the same thing: "I'll bundle the loans, gut the value and sell what's left over to a mutual fund manager". The both of them should be in jail! We need some way of keeping that stuff under control and trusting our elected officials doesn't seem to be getting the job done.

So the reason that the stimulus has had no effect is because it wasn't properly targeted. What we are experiencing is a balance sheet recession where main st. has too much debt. The stimulus did nothing but add to bank reserves and the money isnít actually getting into circulation. Main Street deleveraging continues unabated. Additionally, high unemployment and idle production capacity exacerbates the situation. As it stands, banks are holding cash, loan demand is weak and velocity is minimal. ...........Have to go to work now but I'll respond to your inflation concerns later today.

But you do know where the Fed was trying to go with the money, right? I'm assuming that you've been keeping up with the news about housing and the trouble with the carmakers. If people's mortgage payments are worth more than the market values of their homes, shopping and other "consumer activities" can go out the window very fast. Unfortunately, were to actually succeed in bringing housing prices back up, that could have the effect of driving even more people from their homes because of the affordability issue. The reason I mention this is because housing is one of the top economic concerns in this country right now, and many Americans are simply opposed to the Fed trying to prop up housing prices. Other things that have gone up in price are utilities, healthcare expenses, and education costs.

Also, the Deficit is not simply a numbers issue that can be solved by simply rearranging the accounting records. There are various programs like the "War on Terror", the healthcare entitlements, social security, transportation infrastructure, and even farm subsidies. Since you're new to the board, we need to hear your views on the other issues to see which Government programs would help the economy and which ones would simply enrich the lobbyists.